The Gold-Silver Ratio and Credit Spreads

We recently presented a long term chart of the gold-silver ratio. Traditionally it has been a leading indicator of credit spreads, as during times of declining economic confidence silver, which has a large industrial demand component, tends to fall against gold (which is what this ratio depicts, only vice versa).

Our comment below the chart went as follows:


The 'fly in the ointment' chart. In spite of the big party the markets threw on Friday, the gold-silver ratio has broken through a long term downtrend line this year. This bodes ill for the medium to long term outlook for stocks and junk bonds, as the ratio tends to work as a proxy and leading indicator for credit spreads. Note in this context that junk bond issuance has recently diverged bearishly from the stock market (namely at the early April high in the SPX). This is a phenomenon that was last observed in 2007."

 

This prompted a reader to ask us to clarify this comment further in an e-mail exchange. We thought it might also be of interest to other readers and our further thoughts on the matter follow below:

Per experience, major trend changes in this ratio precede credit distress with a lead time varying from a few weeks to a few months (as always, this is more art than science). It is a heads-up that 'risk assets' of all kinds could get into trouble as the year goes on, provided the ratio does not reverse convincingly.

Since the AU-AG ratio's peak during the 2008 crash, it has been in a long term downtrend – since the downtrend line has recently been breached, a warning signal is currently held to be operative.

The industrial and fabrication demand for silver has remained fairly constant (or rather, has grown very slowly) over the past decade. The loss of demand from the photography sector was more than made up by demand growth in other sectors. What growth there has been has mainly come from investment demand.

One of the reasons why it makes more sense to use silver than e.g. copper or crude oil for this exercise, is precisely based on the fact that the large above-ground supply of silver held for investment purposes is providing a large supply cushion – this means that the silver market is as a rule not subject to unforeseen supply shocks.

For instance, in crude oil one could imagine a scenario where political tensions in the Middle East drive up its price in spite of declining economic confidence. In copper, it may happen that strikes at very large mines in Chile could prop the price up, a drought might influence grain prices, and so forth.

Platinum, another metal with both precious and industrial metal characteristics is also somewhat less useful for using it in this type of indicator, as its production is highly concentrated in one place (75% of it is produced in South Africa) and supply disruptions are both likely and can not be buffered easily. The platinum market is small and often highly volatile.

This is not the case with silver: for one thing, the bulk of its production is widely dispersed and mostly a by-product of base metal mining, and secondly the large stock held for investment purposes will always be available to offset any major disruptions from the supply side.

Silver is in that sense uniquely qualified to reflect perceptions about future industrial commodity demand. Very occasionally there will be distortions in the price due to an unexpectedly big surge in investment demand, but these are actually quite rare (we could only name two over the entire post WW2 period, and the second one, which happened in early 2011, happened to coincide with waxing economic confidence anyway).

Gold's price on the other hand is almost entirely a function of investment or monetary demand (with reservation demand the biggest component thereof). Regardless of whether gold was 'fixed' against currencies during the gold standard, or whether it was free-floating as it is now, its price has always tended to rise relative to other commodities and goods when economic confidence was waning.

 


 

The gold-silver ratio over the past three years: 'QE2' led to a sharp increase in economic confidence; then investment demand increased sharply as new bullion-backed silver ETF's were introduced. Since the end of 'QE2', confidence has been waning again – click chart for better resolution.

 


 

On the question whether specific types of credit are by experience more likely to be affected that others by the change in conditions signaled by moves in the gold-silver ratio, we replied that it is not so that one can pinpoint specific spread products as being especially susceptible.

Rather, the Au-Ag ratio must be seen as a more general indicator: it is highly sensitive to changes in perceptions about the economy. Often when it gives either a negative or a positive signal, we will concurrently observe some initial disturbance, respectively signs of betterment, at the edges of the credit markets.

Often these will be things that barely anyone notices. Below are two pertinent charts from a recent report by Elliott Wave International (EWI). The first one depicts the volume of junk bond issuance relative to the price performance of the Dow Jones Industrial Average.

What is important in this chart are the divergences (both at highs and lows). What is noteworthy at the moment is that as in 2007, the demand for junk bonds has receded slightly even as the stock market made new highs (one can also see that the opposite type of divergence occurred near the 2009 lows).

 


 

Via EWI, a chart that shows the price performance of the DJIA against the volume of junk bond issuance. At both market highs and lows divergences will tend to occur – click chart for better resolution.

 



Similarly, the spread between treasuries and industrial bonds graded B has been making a higher low recently. These are only very small signals, and like the Au-Ag ratio signal may yet be invalidated, if these data points change in a positive manner very quickly. But taking all of them together, they represent an early warning signal.

 


 

 

T-note versus B-rated corporate debt spread: diverging again as well – click chart for better resolution.

 


 

Regarding which types of credit may come under the most pressure, one could probably simply argue that the lower the credit quality, the greater the pressure will be. Right now, junk bond prices remain extremely strong, so aside from the stress in European credit markets (mainly in sovereigns and banks), the world seems fine.

However, this is always the case when the first warning signs appear: the world is still fine when they do.

In the end, a general case of credit revulsion will likely make its appearance, i.e., the troubles will spread from the corner to which they now seem confined to the rest of the credit world.

Consider in this context also the next chart below: the price of JNK compared to the JNK-TLT ratio. Here we have another divergence that one should classify as a subtle warning sign.

 


 

JNK against the JNK-TLT ratio – it is probably no coincidence that this divergence appears while the gold-silver ratio is rising – click chart for better resolution.

 


 

One can compare this with what happened from 2007 onward: in the beginning, only sub-prime mortgage debt came under pressure. Officials and their advisors all insisted that the troubles would remain 'contained' to this sub-sector. But they rarely do remain so contained – in the end it is always 'all one credit market' to paraphrase Bob Hoye. The differentiation between various types of credit instruments that the market makes at the moment will increasingly disappear if/when the crisis intensifies and spreads.

One can observe this phenomenon also by studying the behavior of credit default swaps on European and CEE sovereigns over the past three years: whenever the market recovered, perceiving that the crisis was about to end or pause (i.e., every time it appeared that the can had been kicked down the road successfully), the market began to treat CDS on every country differently. Every sovereign debtor was assessed on his own merits and correlations between CDS declined sharply (the 'better credits' saw much bigger declines in their CDS spreads than the 'bad credits').

Whenever the crisis flared up again, correlations immediately began to become much stronger again – individual merit was overruled by contagion fears.

Our advice would be to keep a close eye on the Au-Ag ratio to see whether or not it falls again, and to keep an eye open for all the small divergences or other small 'yellow flags' that may become noticeable in credit markets. If the 'yellow flags' begin to proliferate and the Au-Ag ratio keeps rising or refuses to decline, the probability of a major 'risk off' event sometime later this year must be considered to be very high.

 

Addendum: Higgs Boson Found

The elusive Higgs Boson, a particle with a mass of 125 giga electron volts, the existence of which scientists have been trying to prove experimentally since Peter Higgs first postulated its existence almost fifty years ago, has paid a brief visit to the Large Hadron Collider at CERN last week.

To be precise, 'there was a signal at 125 giga electron volts', no more. The particle equivalent of a quick 'hello there'. It will take a few months of sorting through the data from the historic particle collision to be 100% sure that it was indeed the Higgs Boson that has been spotted. However, nuclear physicists seem quite happy with that little signal and Higgs suddenly looks like a very likely candidate for a Nobel Prize.

The Higgs particle was the missing link in the so-called 'standard model' – it is what supposedly 'lends' the rest of the particles mass, and allowed them to coalesce into galaxies after the 'big bang'. Not only would the discovery complete the standard model, it is also to be expected that closer scrutiny of the data will reveal still more information about the universe.

Unfortunately, as CERN remind us, 'matter makes up only 4% of the universe' (normal matter, that is). So there's still a lot for physicists left to do.

Steven Hawking lost a $100 bet on the discovery of the Higgs (he had bet that the Higgs particle wouldn't be found, but something else 'even more amazing'). Hawking recently held a party for time travelers, mailing out the invitations after the party was over. Nobody showed up, so the laws of causality seem safe for now.

As an aside to all this, gold is the by-product of dying suns – it is only produced in the crucible of a supernova.

 


 

There it is….the Higgs Boson drops in.

(Image credit: CERN)

 


 

And it was hiding in here all this time…the Large Hadron Collider at CERN

(Image credit: CERN)

 


 

 

 

Charts by: Elliott Wave International, StockCharts


 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

3 Responses to “The Gold Silver Ratio As An Early Warning Indicator”

  • therooster:

    BB … does there really need to be an authority other than the market and its ability to morph toward a more holographic structure now that we have entered a real-time trading paradigm that includes gold-as-money ? I think we all default to top-down hierarchical thinking on the basis that we’ve been supply driven since “the apple was shoved in our faces.” Times change.

    The age of information is like a new wineskin , capable of holding and fermenting new wine …. real-time digitally weighted gold & silver being prime examples. Never forget the gifts of the magi.

  • Monty Capuletti:

    Interesting catch on AU/AG but WAYY too early IMO based on your chart. Neither decisive, nor durable yet, and same on JNK/TLT…Industrial B spreads ARE concerning though, hidden behind the artifice of absurdly low nominal yields and strikingly strong performance from HYG & IG credit driven primarily by massive flows.

    However, where I see things differently (ck my record in comments- 5/5 this year) vs the ’07 parallel is that equity markets are acting DECISIVELY better SO FAR- with quietly bullish divergences building in cumulative breadth, new hi’s, and systemic credit stress indicators ex-sovereign debt and telling a very different story vs ’07 despite the building wave of global economic distress. It’s perplexing, but whereas the Mar/Apr SPX peak period was screaming that the market was about to take one on the chin, outside of a pretty overbought ST market, those same signals in my book have gone dark. That tells me there’s another wave up coming and to hold off on aggressively shorting the market here…The power of this wave also signals that you won’t have to wait long to see it..1,400 SPX by end of July seems likely

  • Belmont Boy:

    This physics stuff is great. I can’t get enough of it.

    But, Pater, I wonder: if experimentation now requires machines on the scale of the LHC, how do we with a small-is-better libertarian point of view come to terms with that? How, in a less centralized world, can there be an “authority” of some sort to rustle up the resources, and coordinate their application, so as to satiate the growing appetite of experimental physicists?

    Lucky Archimedes. All he needed was a full bath tub.

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Pushing Past the Breaking Point
      Schemes and Shams Man’s willful determination to resist the natural order are in vain.  Still, he pushes onward, always grasping for the big breakthrough. The allure of something for nothing is too enticing to pass up.   From the “displays of disbelief, revealing touching old-fashioned notions” file... [PT]   Systems of elaborate folly have been erected with the most impossible of promises.  That prosperity can be attained without labor.  That benefits...
  • The Myth of Capitalism - A Book by Jonathan Tepper
      Crony Capitalism vs. Free Markets Many of our readers are probably aware of the excellent work our friend Jonathan Tepper does for Variant Perception (VP)*****, a financial research boutique that really does bring a unique perspective to the table*. Jonathan (with co-author Denise Hearn) has just added a new book to his résumé, which is going to be released on 12 November: The Myth of Capitalism (MoC) – Monopolies and the Death of Competition** (a link to the official site is at the...
  • Three Cheers for James Riley!
      Going All In All people, of both good and questionable character, share a singular talent.  They excel at taking something that’s tolerable in moderation, and then pushing it to the outer limits of absurdity.  Why live with restraint when you can get radical?   A fairly famous stretch of LA riverbed graffiti... [PT] Photo credit: saber   Public and private debt levels, NASDAQ stock valuations, the federal register, face tattoos, canned energy drinks.  You name...
  • Crumbling Piles of Sand
      Just a Little Avalanche or an Implosion? A few years ago, we briefly discussed the dynamics of sand piles in these pages, which are a special field of study in mathematics and physics (mathematically inclined readers can take a look at two papers on the subject here:”Driving Sandpiles to Criticality and Beyond “ (PDF) and  'Games on Line Graphs and Sand Piles “(PDF) – unfortunately two other studies that used to be available have in the meantime disappeared from the...
  • When Fake Money Becomes Scarce
      Remaining Focused A rousing display of diversions this week assured the American populace was looking every which way but right under its collective nose.  Midterm elections.  White House spats with purveyors of fake news.  The forced resignation of Attorney General Sessions...   Old drug warrior (otherwise recused) on his way home to Alabama...   Sideshows like these, and many more, offered near limitless opportunities to focus on matters of insignificance.  Why...
  • Fun and Profit - Precious Metals Supply and Demand
      While Not Saving The Planet, Let Us At Least Have A Good Time The price of gold went up seven bucks, and that of silver rose eight pennies. For many people, the attraction to gold and silver began with a desire to protect themselves from the monetary train wreck of 2008. That often grew into a sense that gold is the solution to that problem.   The post 2008 GFC monetary train wreck: US true broad money supply is expanded by more than 153% in a mere decade, as the Fed takes...
  • Wizard’s First Rule – Precious Metals Supply and Demand
      The Last to Go Terry Goodkind wrote an epic fantasy series. The first book in the series is entitled Wizard’s First Rule. We recommend the book highly, if you’re into that sort of thing.   An image from the title page of Terry Goodkind's best-selling fantasy epic “Wizard's First Rule”. We'd be at bit wary of standing around on that stone-slab bridge to be honest. [PT]   However, for purposes of this essay, the important part is the rule...
  • US Stock Market - Re-Coupling with a Panic Cycle?
      The Mighty Gartman Investment newsletter writer Dennis Gartman (a.k.a. “the Commodities King”) has been a target of ridicule at Zerohedge for a long time. His pompous style of writing and his uncanny ability to frequently make perfectly mistimed short term market calls have made him an easy target.* It would be quite ironic if a so far quite good recommendation he made last week were to turn into the call of a lifetime (see ZH: “Gartman: 'We Are Officially Recommending Shorting...
  • Roger Barris for Congress!
      Economic Man Threatens to Leave You Alone if Elected This one is mainly for readers residing in that glorious water source for California commonly known as Colorado. In case you are not aware of it yet, Roger “Economic Man” Barris, an occasional contributor to this site, is running for Congress in Colorado on a Libertarian Party ticket. We will briefly explain why you should vote for Roger, but first two pictures:   Roger Barris, Libertarian Party candidate for the House...
  • Revisiting the Halloween Effect
      From Crash Danger to End-of-the-Year Ramp   [Ed note by PT: we are unfortunately a week late in posting this issue of SI, which didn't reach us in time due to a technical problem. We decided to post it belatedly anyway: for one thing, the effect under discussion is normally in effect until the end of the year; for another, the statistical validity of this information goes beyond the current year, as it is a recurring phenomenon. Lastly we would note that we have a strong...
  • It's Not That Day Just Yet - Precious Metals Supply and Demand
      Degrees of Urgency Monday was Veterans Day, a bank holiday in the US. The prices of gold and silver dropped $23 and $0.61 respectively. “But isn’t gold supposed to go up when...?”   Warren Buffet and Aragorn discuss what to do with the gold. Aragorn wants it, because he knows that even if it's not today, “that day” will come. [PT]   Why? Because everyone else will bid it up. Why? Because they expect someone else to bid it up. Why? Warren Buffet is...

Support Acting Man

Item Guides

Austrian Theory and Investment

j9TJzzN

The Review Insider

Archive

Dog Blow

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!